Adjusting a Trade Gone Bad...and Good

by Carley Garner of DeCarley Trading

Experienced option traders are aware of the dismal probabilities involved in long option strategies. It is often said that approximately 80% of all options will expire worthless. Thus, it is fair to say that option buyers will likely lose all or some of their investment. Accordingly, option sellers are provided with arguably better odds of success. In theory, more often than not, sellers will collect but more importantly keep, the entire premium of a short option. Naturally, they must be careful not to let the few losing trades take back all previous profits plus some. Thus, due to the delicate nature of the options market it is imperative that all traders, whether buyers or sellers, have the ability to “repair” option positions in order to maximize their odds of success.

As with many aspects of trading, adjustments are not an exact science but a skill. In fact, sometimes it is even necessary to adjust your adjustment. With that said, you must realize when an adjustment is necessary and when doing so will simply add unnecessary risk or transaction costs. We have chosen two scenarios in which we would like to demonstrate option repair strategies using a bull call spread with a naked leg.

An Aggressive but Seemingly Wise Approach to Options on Futures

We are somewhat fond of a three-legged debit spread known as a bull/call or bear/put spread with a naked leg. These types of option spreads are consistent with the theory that options are priced to lose. Thus, rather than buying a close to the money option out right, traders should finance the position by collecting premium through short options. Such a strategy is relatively aggressive shouldn't be attempted by the faint of heart.

Traders that are expecting a market to rise can increase their leverage, and in my opinion the probability of a profitable trade, through the simultaneous purchase of a close-to-the-money call option and the sale of a higher strike call option as well as a "safely" positioned short put. The beauty of the trade is that you can’t lose on all three legs of the trade. In other words there is a built in diversification mechanism. Conversely, this type of spread involves unlimited risk in the form of a naked put, making it imperative that traders are prepared to adjust their stance or simply exit the trade should the market turn sharply against the position.

A three-legged spread structured in this way can, and should, be adjusted in two completely different market scenarios; the first being an attempt to “repair a trade gone bad” the other being an opportunity to “milk the trade for additional profits”.

The Trading Plan

As you have heard time and time again, you must have a plan of action going into a trade. The point at which you chose to adjust should be determined in advance, however every successful trader understands that it may be appropriate to stray away from the original plan and unfortunately this is something that only comes with experience. When trading Dow futures, a rule of thumb is to convert a naked option into a debit spread once the underlying future comes within 100 points of the strike price if there is 20 days or more left until expiration and momentum oscillators are suggesting that the momentum is against the short option position. Another point of reference as to when to exit a losing short option is what we call the double out rule. If the short option doubles in value from the point of entry, it is probably fair to say that the original speculation was incorrect and the risk should be taken off the table.

Remember, rules of thumb are created so that they can be broken. In other words, don't fixate yourself on such a general rule that you ignore everything else around you. Just because the criteria has been met doesn't mean that you should immediately exit the position and evaluate the situation after. Emotions, namely fear, can make staying calm in the heat of the moment very difficult.

Volatility Doesn't Always Bring Trading Opportunity

Any trader will tell you that April of 2005 was an exceptionally unpredictable and volatile month in the financial markets. One could have easily been fooled by the chart of the June Dow Jones future. As you know, the Dow traded in a very distinct trading range throughout 2004, and it appeared as though it was setting up to post similar action in 2005. After peaking in early March, the Dow appeared to have found support around the 10,400 area. This is precisely the point in which the market found a bottom in January of 2005, providing an opportune time to execute a bullish option spread

According to theoretical data, on the 13th of April 2005 a trader could have bought a June 10400 call option for $2095, sell a June 10700 call for $775 and sell a June 10100 put for $1075. The total out of pocket expense of the spread would have been $245 plus transaction costs, with a total maximum profit potential of $2,755 ($3000 - $245), the difference between the call strike prices minus the original cash outlay.

Table 1 Bull Call Spread with a Naked Leg

Option

Long/Short

Debit/Credit

June 10,400 call

Long

-$2095

June 10,700 call

Short

$775

June 10,100 put

Short

$1075

Total position debit/credit:

-$245

Figure 1

However, as we all know, things are not always as they seem. Rather than holding support and heading to the top of what was believed to be the trading range, the Dow quickly dropped. At this point a trader can do one of three things, liquidate the short put at a loss, wait and hope that the market rebounds, or adjust the trade.

An Oscillator is an Oscillator, in the Long Run

We have concluded that a short term moving average crossover, such as the 3 and 7 day, provides good indication of upcoming price moves but should only be acted upon if confirmed by a trend following oscillator such as the MACD using an 8 and 20 day exponential moving average with a 9 trigger. A combination of a MA crossover and a slower indicator is a better judge of the underlying trend relative to a quicker oscillator such as stochastics and may help traders avoid premature reaction to false market moves. Keep in mind, that these are simply personal preferences you may be comfortable with alternate oscillators and as long as you use them consistently should yield similar results in the long-run. This is because all oscillators are simply mathematic equations representing what has already happened in the market and are likely equally as effective, or ineffective, depending on how you use them. The combination of oscillators used should be determined by your risk level and personality combined with comfort level.

Along with help from an oscillator, it is also important to note any known support and resistance areas. A break out with a close near the high or low suggests that the market will continue in the direction of the move but it certainly isn't guaranteed. As you can see, the rules of option trading are extremely ambiguous. Accordingly, repair strategies take a great deal of instinct and self-control.

A quick thinking trader can quickly mitigate, or even eliminate, losses on an unfavorable trade by converting the naked put into a bear put spread. In this example, buying a 10300 put will not only guarantee limited loss on the downside, depending on the time value left on the trade and other market conditions, it may be possible to profit on the adjustment even though the trader was 100% wrong on the direction of the market.

However, as you will soon see, this is a lot easier said than done. After all, it is entirely possible that the market could bounce shortly after buying the 102 put causing a loss on the adjustment as well as the original spread. Additionally, markets tend to gyrate rather than going straight up or straight down making both entry and exit of the adjustment very confusing. Another factor working against this type of adjustment is the likelihood of increased price volatility leading to inflated option premium.

Don't Panic, Get Creative with Option Trading

On April 14th, one day after executing a trade that seemed to have a perfect set up, the June Dow Jones futures contract impulsively dropped though previous market support and settled near the low of the day. At this point, the market has violated many of the previously mentioned “rules of thumb” in Dow futures trading. Thus, an adjustment seems necessary. Based on Black and Scholes data, a trader could have purchased a 10300 put on the open of trading on the 15th for $2025. The net result is a 10300 / 10100 bear put spread, along with a 104000 / 10700 bull call spread above the market.

Purchase of the 10300 put for $2450, if left intact, provides an opportunity to profit on the put spread if the market is below 10100 at expiration. After all, we originally collected $1075 for the 10100 put and the spread can make as much as $2000 intrinsically. This would give us a profit of $625 intrinsically below 10100. Conversely, we cannot forget about the money that is lost on the call spread. Assuming the call spread is held until expiration and expires worthless, even the maximum payout on the put spread would leave the trader in the hole by about $695 before transaction costs. While this doesn’t sound like an exciting proposition for most futures traders, it far outweighs the alternatives.

Table 2 Creating a Bear Put Spread from a Naked Put

Option

Long/Short

Debit/Credit

June 10,400 call

Long

-$2095

June 10,700 call

Short

$775

June 10,100 put

Short

$1075

June 10,300 put

Long

-$2450

Total position debit/credit:

-$2695

Once a naked option is “repaired”, the trader now faces the decision to either hold the adjustment into expiration or attempt to trade out of it. This can be even trickier than placing the adjustment itself. If not handled properly, a trader can easily be “whipsawed” in and out of the market resulting in substantial losses.

Figure 2

In the simplest scenario, the Dow would have declined below 10,100 and remained there until expiration. However, the June Dow found support just about 10,000 and made an impressive rebound forcing a trader in this position to assess the market and determine if and when to begin “legging out” of all or part of the trade. In a situation such as this, it is critical that a trader not panic and liquidate legs prematurely. For this reason, similar to entry of the adjustment, exit should be triggered by a crossover of the 3 and 7 day moving average along with confirmation from the MACD or any other combination of oscillators that you have faith in.

On April 25th, the MACD triggered bullish signal, which confirmed a MA crossover indicating that the market could be headed higher in the near term. This should also be seen as an opportunity to sell the previously purchased 10300 put. After all, options are an eroding asset. It doesn’t make sense to hold a long put if technical momentum appears to be pointing towards higher a higher Dow. By selling the long put on the open of the trading session, the trader may have received $2225, a loss of $200 plus commissions and fees on this particular leg but worth it in terms of sanity and potential sleep loss.

We are now left with the original trade, a 10,400/10,700 call with a naked 10,100 put and a net cost of $445, rather than $245, and a profit potential of $3000 with the market set to incline.

In this particular trade, it appears as though a trader would have been better off without adjusting. By keeping the original spread intact and withstanding the fluctuation, a trader could have avoided the $200 loss incurred and the extra commission paid for the adjustment put. But keep in mind; the potential loss was much greater.

Adjusting Profitable Option Spreads

As previously mentioned, a three-legged spread such as this can also be adjusted in a scenario in which the market does in fact go in the intended direction. Let’s take a look at an example in which the trader is correct in the speculative direction of the market and has the opportunity to “extract” a little more profit from the trade.

Figure 3

In mid July, the Dow made an impressive comeback following the panic liquidation triggered by the terror attach in London. After analyzing the technical aspect of the market a savvy trader may have found this to be the perfect time to enter the market with a bull call spread with a naked leg. A failed breakout of the trading range is one of the most reliable indicators for future price action. According to the information available to us, on July 11th, a trader could have bought a September Dow 10,400 call, sold a 10,800 call and a 10,000 put for a total cost of $325 before commissions and exchange fees.

Unlike the last example, the market immediately goes in favor of the trade. When trading three legged option spreads, it is important to remember the old adage “You can’t lose taking profits.” By carefully exiting the trade one leg at a time, I believe that it is possible to maximize your odds of success while minimizing your risk.

Table 3 Bull Call Spread with a Naked Leg

Option

Long/Short

Debit/Credit

Sept. 10,400 call

Long

-$1750

Sept. 10,800 call

Short

$400

Sept. 10,000 put

Short

$1025

Total position debit/credit:

-$325

The bulk of the risk of this trade lies in the naked put, thus this is the first leg that we will look to liquidate with a profit. Once again we will look to technical analysis to guide our decision, however this time we will also monitor the time premium erosion of the naked put. Option sellers should consider taking profits, and risk, off of the table once the value of the option has eroded to less than 40% of the premium collected. From there decisions should be guided by the direction and stamina of the current trend measured by technical indicators such as the MACD. If it gets to the point in which 80% or more premium has eroded, you should no longer be considering whether or not to buy it back you should simply do it.

On July 18th, the value of the September 10,000 put has declined to $400 meeting are criteria to begin consideration of buying the option back at a profit. Next, a trader should look to their favorite oscillator to determine the direction in which they believe that the market will go in the short term. If indicators are pointing towards a rally, a trader would be best off holding out in hopes of additional profit. However, if it appears as though the market might weaken, it is time to take profits on the short put. On July 25th, the trend oscillators are beginning to look as though the market is prepared for a correction. Additionally, the Dow is finding significant resistance as it approaches the June highs. At this time, a prudent trader would look to buy back the put for $350 according to theoretical values to take a profit of $675 on that particular leg. This is a good idea even though the oscillator hasn’t actually given the signal.

Figure 4

The offset of the put eliminates a significant amount of the risk in that there is no longer unlimited danger, and leaves the trader with a limited risk bull call spread. The next step in the adjustment process is to sell the long 10,400 call. Similar to legging out of the put, selling the call should be based on technical analysis. Naturally it would be ideal to liquidate the call option at the top of the market, but I think we all realize that this is easier said than done. Once again, we should rely on the MACD to guide liquidation of the long call. At the time of the MACD crossover, a trader could have collected $3225 for the 10,400 call option to net a profit of $1475 before commissions and fees.

Figure 5

Option Spreads Can be Picked Apart

At this point the only remaining leg of the trade is a short 10,800 call, in which was originally executed as a credit of $400 and is now worth about $850. This represents a $450 paper loss on this leg of the spread. In line with the proverb “have your cake and eat it too”, a trader can hold the short 10,800 call in hopes of the market weakening and thus depreciate in value and add to the overall profit of the trade. Once left with a naked call, a trader should look at the remaining leg as though it were executed for the sole purpose of premium collection. This may avoid temptation for excessive greed or just the opposite, undue fear.

Table 4 If you exited the short call along with the long call.

Option

Long/Short

Debit/Credit

Exit price

P/L

Sept. 10,400 call

Long

-$1750

$3225

$1475

Sept. 10,800 call

Short

$400

$850

-$450

Sept. 10,000 put

Short

$1025

$350

$675

Total position debit/credit:

-$325

Total P/L:

$1700

Although the short call involves risk, it provides a trader with attractive odds. After all, time premium will decay on the option regardless of whether the market trades higher, lower or sideways given that the market doesn’t rally too quick and too far. With a current value of $850, unless the trader expects that the market will rally to 10,885 by expiration, there is little justification in buying the call back. In other words, it only makes sense to buy back the option if the trader believes that the market will be above 10,885 at expiration because this level represents the trader’s intrinsic break-even point based on the value at the time that the long call was offset.

If everything goes as planned this option will lose value and allow the trader to buy it back at a discount. The best-case scenario would involve an impulsive drop ensuring that the 10,800 call expires worthless. If this is the case a trader would have profited on all three legs of the option spread. Let’s do the math, we made $675 on the short put, $1475 on the long call and can potentially make another $400 on the short call for a total of $2550 before commissions and fees ($850 better relative to the timing of the exit of the other two legs which would have netted $1700). Don't overlook the fact that there were three contracts traded and would have created three round turn commission charges.

While this is less than the $3675 ($4000 - $325) maximum payout at expiration, I believe it to be more likely. In order for the original spread to return the maximum payout the market would have to be above 10,800 at expiration. Given the technical climate of the market and the seasonal weakness it doesn’t seem a probable outcome. Additionally, holding a trade too long can often lead to a winning trade turning into a losing trade. Accordingly, I am of the opinion that taking profits one leg at a time reduces a trader’s exposure to the market while increasing their odds of success.

The Bottom Line

In conclusion, options are an extremely versatile trading tool with the ability to provide traders with a potentially lucrative alternative to trading futures contracts. However, in order for option trading to be effective it is sometimes necessary to make adjustments and even repair a particular trade. With a combination of skill, instinct and luck the flexibility of options offers traders the potential to profit in a market regardless of its direction.

**There is substantial loss in trading options and futures.

Carley Garner, senior analyst at DeCarley Trading, is the author of "A Trader's First Book on Commodities" and “Commodity Options” published by FT Press, a division of Prentice Hall. Her trading e-newsletters, The Stock Index Report and the Bond Bulletin, are widely distributed and have garnered a loyal following; DeCarley Trading is proactive in providing free trading education.

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